Due Diligence: More Than Quality of Earnings

Today’s private equity landscape is marked by fierce deal competition and high valuations, and evaluating a target company is as important as ever for a PE firm. While financial due diligence and assessing the quality of the target’s earnings are important, effective due diligence goes far beyond a review of the financials. To properly evaluate a potential investment, leading PE firms take a comprehensive view.

Due diligence can be broken into two main areas of review: commercial and operational.

Commercial diligence

The goal of commercial diligence is to gauge the target’s current state and potential for economic growth. Typically, these factors can be bucketed into market, company, and fit.

A proper market analysis will include topics, such as macroeconomic factors, total addressable market, market share, industry analysis (such as 5-forces), industry trends, and industry players.

Evaluating the company bucket is about trying to understand what value the target provides and how it goes to market. Some important factors here would be products, customer profile, customer economics (acquisition cost, lifetime value, etc.), sales and marketing strategies and their effectiveness, positioning relative to competitors, and target customers in comparison to total addressable market.

The final bucket in commercial diligence is fit. This analysis determines how well the target is aligned to the investor. Does the target align to the investor’s investment strategy? Are there synergies that can be derived across the investor’s portfolio? Is there a cultural fit between the target investment team and management team? Often overlooked, these factors can be some of the most critical to an investment’s success.

Operational diligence

The goal of operational diligence is to determine the health, capabilities, and scalability of the target.

Accounting and financial review are what most people think of when they hear due diligence. This is where quality of earnings, financial statement analysis, working capital analysis, and the like are performed.

Technology infrastructure analysis is a growing need in today’s investment landscape. Many acquisition targets lack the underlying infrastructure necessary to meet even basic reporting requirements, much less to support large scale growth. Often this leads to large, and sometimes unexpected, capital expenditures. It is important to note in the case of a technology company, the technology the target sells would fall under commercial diligence.

The goal of supply chain analysis is to uncover any risks associated with the target’s fulfilling their performance obligation to their customer and to assess the target’s ability to scale. Specific focus areas vary greatly depending on type of target, but some common examples include sourcing, manufacturing, and distribution capabilities for targets that deliver physical goods and engineering and support for technology companies.

Getting a good understanding of human resources can be a difficult task in a pre-investment situation. Most deals are confidential; therefore, investors only have access to a small number of employees. That being said, it is good practice to understand risks and capabilities to the extent possible.

The final two buckets are tax and legal. While mostly self-explanatory, these two buckets can have large implications. It is critical to have a firm understanding of both areas before structuring an investment.

At MorganFranklin, we have deep expertise in all areas of due diligence. We act as a cross-functional extension of your team to help you navigate the complexity of due diligence through one central point of contact.

2019-02-18T22:22:55+00:00February 18th, 2019|Insights, Insights - Companies|